A collection of often sceptical, always candid observations and insights on the US economy and large-cap equity markets. Readers have observed my style and perspective to be that "the emperor has no clothes," and that is reasonably accurate.
Postings reflect my philosophies and perspectives on economics, business and politics.

Friday, November 09, 2007

I've been seeing a lot of annoying BP (formerly British Petroleum) commercials lately on television.In times past, BP knew it was, basically, an oil company. Here's one of their old commercials.Now BP has alternative energy information on its website, and commercials more in this direction, although it does not appear to be a very recent one.Here's a more modern BP commercial, actually condemning petroleum usage....This is giving me a serious case of deja vu. Could BP be channeling the failed spirit of the long-defunct, once-proud railroad, Penn Central?While I generally eschew using Wikipedia, due to the nature of its entries being susceptible to manipulation, in this case, I can vouch for its correctness. It reads, in part,"Penn Central management created a holding company, the Penn Central Company, and tried to diversify the troubled firm into real estate and other non-railroad ventures, but in a slow economy these businesses performed little better than the railroad assets. In addition, these new subsidiaries diverted management attention away from the problems in the core business. To make matters worse, management insisted on paying dividends to shareholders to create the illusion of success. The company had to borrow more and more to keep operating. The interest on the loans became an unbearable financial burden."Penn Central, whose new corporate mission statement self-identified it as "a transportation company," in keeping with the then-new fad of formalized corporate planning, declared bankruptcy in 1970.BP is now an 'energy company,' just like Penn Central left railroading to become a 'transportation company.'The real estate, among other things, tripped up Penn Central. Plus the distractions of trying to learn and manage non-railroad businesses.What do wind and solar energy share with oil exploration and production? Why do we think that a company with a long history of success in the latter will be advantaged to compete in the former?Look, this blog has its title for a reason. I'm generally sceptical. I'm really sceptical about BP's shift from its core competencies in petroleum-based businesses to totally new endeavors, in different technologies.You know what these different energy-related technologies share? A need for capital. BP is behaving more like a bank than a petroleum company. But BP isn't a bank. Nor an energy company. It's an oil company.Let's see...where have we seen this happen before...in the oil sector....oh yes! Exxon in the 1970-80s!My very first trip to New Jersey was as a consultant, working for the Wharton Applied Research Center. We advised the solar energy business of Exxon Enterprises.At the time, the oil giant had decided that its future as an explorer for, and producer of oil was clouded, and that various information technologies would quench the world's thirst for oil.Thus, Exxon created a separate unit, Exxon Enterprises, to 'let a thousand flowers bloom,' as it were. They bought early fax and other information services technologies, such as Quip and Qyx, invested in solar energy, and the like. After something like a decade, Lee Raymond shut down the expensive failure.Today's $90+/bbl oil suggests that Exxon was a wee bit early to the 'energy diversification' dance, doesn't it? But it sounds familiar.Environmentalists and futurists declare the oil era dead, and a petroleum titan obligingly spends hundreds of millions of shareholder dollars buying into technologies about which it essentially knows nothing.Like Exxon and Penn Central before it, I suspect BP will be spending a lot of its shareholders' money chasing businesses and technologies with which other competitors are much more skilled.Doesn't it make more sense to believe that a standalone wind or solar energy firm will commercialize the best technologies in the quickest manner, both for efficiency, as well as to aggressively replace petroleum- or gas-based energy where it makes the most economic sense to do so?My suspicion has always been that an oil company will grudgingly develop alternatives to its main business, and, in doing so, carefully control the pace at which its major product is replaced. The culture of BP is likely to be skewed toward petroleum. I don't think you'll be seeing an alternative energy CEO there anytime soon. And any alternative energy activity will have to grow for years before it's a serious substitute for the earnings from oil-related activities.It simply makes more sense to me that genuinely economic, efficient, effective alternative (to oil and gas) energy solutions will come from companies founded and focused on those technologies. Not oil companies suddenly discovering that they are really energy companies.Perhaps BP's (and ExxonMobil's) time as a commercial giant is coming to an end. Maybe, soon, they will seem like a whale oil vendor in the early 1900s. We don't know yet. We don't even have univocal scientific opinions on whether we have discovered most of the oil on earth that ever existed.But until then, I believe it makes more sense for BP to be the best oil company possible, and, when that is no longer a viable proposition, return its capital to its shareholders, rather than try to subtly become another type of business, with which it has no experience.The Penn Central example ought to be a sobering one for the senior executives at BP.

Thursday, November 08, 2007

Today's Wall Street Journal, entitled "GM Turnaround Shown Off-Track," carries an article discussing GM's announcement, yesterday, that it is taking a $38.6B write down of a tax benefit. The importance of the write off is captured in this passage from the Journal article,"GM's persistently weak financial performance prompted the company to take the big write-down for what are known as net deferred tax assets. They stem from past losses and can be used to offset taxes incurred on current or future profits for a certain period of years. In writing them down, the company is essentially saying it may be unable to use them because it isn't clear that the company will return to black ink in the near term."Regarding GM's results being received by investment analysts, the article reported,"GM's results surprised many analysts because it had appeared to be making progress in stemming its losses, and its global automotive operations were profitable in the first half of the year, helped in part by some hot models like the Buick Enclave and GMC Acadia, new seven-passenger vehicles. The company is finding it can't cut costs fast enough to offset declining industry sales in its core North American and European markets and can't sell assets fast enough to cover the cash it is using up."As I wrote in prior posts, here, here, and, more recently, here, I don't believe GM will successfully execute a "turnaround" with its current management team. Particularly, with CEO Rick Wagoner remaining at the helm of the ailing auto maker.The fact is that GM just lost $39B this past quarter. The face that I watched Rick Wagoner try to put on this appalling loss, in an early morning CNBC interview with correspondent Phil LeBeau, was that it is a non-cash charge that has no real meaning for investors. Skipping over the implicit acknowledgement that removing the asset from GM's balance sheet means the firm has no expectation of returning to profitability anytime soon, Wagoner attempted to paint a rosy picture of the firm's recent UAW contract, and longer term future.As the Journal pointed out,"The big loss occurred even after GM cut tens of thousands of jobs in North America and Europe, launched a volley of new models and boosted revenue in the quarter to $43 billion, a record level."Wagoner admitted that North American sales are slow and headed down. When pressed by Becky Quick on when investors might see profits again, Wagoner launched into a long, deliberately-obfuscating response that avoided giving her an estimate of that date.As I reflect on the last few weeks in American business, I wonder why anyone bothers to interview CEOs of troubled companies at all?Between Stan O'Neal's and Chuck Prince's lack of candor all year long, you have to wonder if any embattled CEO is going to be honest about his and his company's troubles. A face to face interview on CNBC or Fox Business Channel is just an opportunity to engage in damage control. Truth is to be rationed, and high spirits, plus a 'can do' attitude, are to be paraded before the audience of analysts potential investors.I think I'd prefer to view a good discussion by a panel of relevant, experienced observers of a troubled company than be painfully subjected to the propaganda dished out by the CEO of a GM, GE, etc., via live interview, as to why their own numbers are irrelevant, and their company's future will certainly be bright and profitable, come what may.After all, the history of Prince's and O'Neal's statements all year long, and Wagoner's for years, have all belied the actual fundamental operating performances of their firms this year, haven't they?

Wednesday, November 07, 2007

As today's market for oil nears prices of $100/bbl, my thoughts turn to Julian Simon.Simon is eloquently described here, in a piece for the Cato Institute, written by his onetime aide, now Wall Street Journal editorialist, Stephen Moore, upon Simon's' death in February of 1998. He wrote, in part,"I first met "doom-slayer" Julian L. Simon at the University of Illinois in the spring of 1980—at just the time when the environmental doomsday industry had reached the height of its influence and everyone knew the earth was headed to hell in a hand basket. The Club of Rome had just released its primal scream, Limits to Growth, which reported that the earth was rapidly running out of everything. The most famous declinist of the era, biologist Paul Ehrlich, had appeared on the Tonight Show with Johnny Carson to fill Americans with fear of impending world famine and make gloomy prognostications, such as, "If I were a gambler, I would bet even money that England will not exist in the year 2000."

The Carter administration published in 1980 its multiagency assessment of the earth’s future, titled Global 2000. Its famous doom-and-gloom forecast that "the world in 2000 will be more crowded, more polluted, less stable ecologically. . . . and the world’s people will be poorer in many ways than they are today" received headlines across the nation. Malthusianism was now the official position of the U.S. government.

It was all so damned depressing. And, thanks to iconoclast Julian Simon, we now know that it was all so wrong.So for more than 15 years I was privileged to occupy a front-row seat from which I watched as Simon thoroughly and often single-handedly capsized the prevailing Malthusian orthodoxy. He routed nearly every prominent environmental scaremonger of our time: from the Club of Rome, to Paul Ehrlich, to Lester Brown, to Al Gore. (After reading Earth in the Balance, Julian was convinced that Gore was one of the most dangerous men and one of the shallowest thinkers in all of American politics.)The ultimate embarrassment for the Malthusians was when Paul Ehrlich bet Simon $1,000 in 1980 that five resources (of Ehrlich’s choosing) would be more expensive in 10 years. Ehrlich lost: 10 years later every one of the resources had declined in price by an average of 40 percent."This piece from Wired contains the details of that famous bet."The battle lines now drawn, it was not long before Ehrlich and Simon met for a duel in the sun. The face-off occurred in the pages of Social Science Quarterly, where Simon challenged Ehrlich to put his money where his mouth was. In response to Ehrlich's published claim that "If I were a gambler, I would take even money that England will not exist in the year 2000" - a proposition Simon regarded as too silly to bother with - Simon countered with "a public offer to stake US$10,000 ... on my belief that the cost of non-government-controlled raw materials (including grain and oil) will not rise in the long run."

You could name your own terms: select any raw material you wanted - copper, tin, whatever - and select any date in the future, "any date more than a year away," and Simon would bet that the commodity's price on that date would be lower than what it was at the time of the wager."How about it, doomsayers and catastrophists? First come, first served."

In California, Paul Ehrlich stepped right up - and why not? He'd been repeating the Malthusian argument for years; he was sure that things were running out, that resources were getting scarcer - "nearing depletion," as he'd said - and therefore would have to become more expensive. A public wager would be the chance to demonstrate the shrewdness of his forecasts, draw attention to the catastrophic state of the world situation, and, not least, force this Julian Simon character to eat his words. So he jumped at the chance: "I and my colleagues, John P. Holdren (University of California, Berkeley) and John Harte (Lawrence Berkeley Laboratory), jointly accept Simon's astonishing offer before other greedy people jump in."

Ehrlich and his colleagues picked five metals that they thought would undergo big price rises: chromium, copper, nickel, tin, and tungsten. Then, on paper, they bought $200 worth of each, for a total bet of $1,000, using the prices on September 29, 1980, as an index. They designated September 29, 1990, 10 years hence, as the payoff date. If the inflation-adjusted prices of the various metals rose in the interim, Simon would pay Ehrlich the combined difference; if the prices fell, Ehrlich etalia would pay Simon.

Then they sat back and waited.

Between 1980 and 1990, the world's population grew by more than 800 million, the largest increase in one decade in all of history. But by September 1990, without a single exception, the price of each of Ehrlich's selected metals had fallen, and in some cases had dropped through the floor. Chrome, which had sold for $3.90 a pound in 1980, was down to $3.70 in 1990. Tin, which was $8.72 a pound in 1980, was down to $3.88 a decade later.

Which is how it came to pass that in October 1990, Paul Ehrlich mailed Julian Simon a check for $576.07.

A more perfect resolution of the Ehrlich-Simon debate could not be imagined. All of the former's grim predictions had been decisively overturned by events. Ehrlich was wrong about higher natural resource prices, about "famines of unbelievable proportions" occurring by 1975, about "hundreds of millions of people starving to death" in the 1970s and '80s, about the world "entering a genuine age of scarcity."

In 1990, for his having promoted "greater public understanding of environmental problems," Ehrlich received a MacArthur Foundation "genius" award. "No doubt Simon would say that today's high oil prices are the result of supply, so recently managed to closely match modestly-growing demand, temporarily lagging the unexpectedly explosive appetite for oil and gas in China and India.Thanks to the magic of market price signals, this period of high prices for crude oil, and the related rise in the price for gasoline, will bring more suppliers on stream to cash in on the rewards of finding, producing and marketing crude oil.Point in time analyses and observations can lead to mistaken conclusions. Nobody can say precisely for how long we'll see these oil prices. But it's reasonable to believe that substitutes such as oil shale, tar sands, and gasified coal will soon be providing energy sources that will replace some petroleum consumption, thus leading to dampened oil prices.Thus, ironically, a temporary surge in crude oil prices is a good thing. It signals energy producers the world over that more investment in crude exploration and production will be rewarded with high prices for the first to come to market with new supply.

Last week I wrote this post on the occasion of Merrill's CEO, Stan O'Neal's departure. In it, I paid attention to O'Neal's outgoing compensation, and suggested that financial service company boards include a clause in a CEO's contract (under which, we have subsequently learned, neither O'Neal nor Citigroup's just-departed CEO Chuck Prince operated) to deny deferred compensation to a CEO who presides over serious losses. Specifically, I wrote of O'Neal,"Here's a guy who presided over, and abetted, the loss of more than $8 BILLION this year, and he still walks with $160MM.I don't care how that $160MM was earned, or over what time period. The truth is, the nature of financial service firms is such that a CEO, or, as I've written recently, here, any senior executive, can play the 'heads I win, tails you lose' game all too easily by risking the shareholders' equity.In this regard, financial service companies are a bit different than those in most other sectors. Pumping growth at a financial services firm often leads to simply taking more risk.In order to help a CEO own the responsibility for not allowing this to happen, why not simply make all deferred CEO compensation over an amount with which the board would not be embarrassed to have a loss-inducing CEO leave, subject to revocation and loss, in the event of certain conditions.These conditions could include the occurrence of loss, as reported on financial statements, exceeding, either annually or cumulatively, a stated amount. Or perhaps a percentage decline in total return, adjusted for the S&P500 Index."Consider Citigroup's Prince, who reportedly walks with $31MM, about which I wrote here last weekend. Citi is under fire for the SIVs it operates, but does not own. That is, it explicitly set up off-balance sheet vehicles which seem likely to cause large losses to the SIVs' lenders and 'senior note holders,' the latter being an equity-like class of investors in the vehicles.Wasn't Sarbanes-Oxley supposed to end this sort of balance sheet slight of hand? Didn't the post-Enron environment cause Congress to pass SOX in order to prevent further financial statement abuses?Guess it didn't work, did it? There's the nation's largest bank, by asset value, clearly engaging in off-balance sheet vehicle creation.I contend that Congress, and investors, would get a whole lot more honesty and accuracy from CEOs and companies if the boards employed the type of deferred compensation reclamation for egregious losses that I suggested last week.Clearly, SOX didn't stop Prince, nor his board, on which sat the former US Treasury Secretary, Bob Rubin.Maybe I'm too cynical, but I'd bet that most CEOs will behave in ways calculated to preserve their tax-preferenced, deferred compensation wealth, SOX or no SOX. Moreover, I'd bet they'll be more motivated to protect their deferred fortunes than they will to avoid a SOX fine or penalty.For a CEO to be stripped of his wealth, and 'retire' or be fired with as little as a few million dollars, is to add financial pain to shame. The latter might pass, but the former brings home much more viscerally the penalties of excessively risky behavior with shareholders' money.Would Chuck Prince have been as cavalier in allowing the SIVs to be created, and so many structured investments assets be held, if he knew that engendering losses beyond some limit would strip him of nearly all of his $31MM exit package? He certainly didn't worry about SOX, did he?Legal penalties for suspect corporate executive behavior is always going to be less certain than the result of a contractual agreement to forfeit assets under clear-cut conditions.Ironically, using conditional deferred compensation clauses of the sort I am advocating might have provided less of a reason for Congress to have resorted to SOX in the first place.

Tuesday, November 06, 2007

Dennis Berman penned an article in today's Wall Street Journal's Money & Investing section, entitled, "Why Street Bankers Get Away With Repeating Old Mistakes."Mr. Berman's pieces are typically interesting and well-reasoned. Today's is no exception. He asks the question, in reference to subprime mortgages and CDOs,"What would happen if Boeing Co. or Johnson & Johnson rolled out products with similar defect rates?"He quotes a money manager as saying,"That's the thing about Wall Street that amazes me. They keep making the same mistakes."Toward the end of his thought-provoking piece, Mr. Berman writes,"Consider another sector of this upside-down world. Over the last few years, standard bank deposits became less desirable. It was too costly building branches and bidding for deposits, especially when more flexible wholesale funding could be created at a moment's notice via fresh short-term paper. That was the reasoning of Countrywide Financial, and a slew of other players such New Century Financial and Northern Rock PLC of the United Kingdom.

It was great, as long as the paper could be repeatedly rolled over. When it couldn't, the companies would be well out of business. But how could that possibly happen?As a hedge-fund manager himself, Mr. Bookstaber acknowledges that in the real world of "normal accidents and primal risks, limitless trading possibilities might cause more harm than good."

Financial cycles are natural, we're told. Of course they are. But they also make a wonderful excuse for lots of bad, or downright dumb, behavior. Does it really have to be?"I actually sent an email to him at the address provided at the article's end, saying, "yes," it does really have to be.Let me explain. A few weeks ago, while talking with my brother, a creative SVP at a major ad agency, he asked me,'What happens to traders and investment bankers when they get older? Do they retire?'And I realized, as I began to explain the industry's career paths, that few people actually understand this key driver of the behavior Mr. Berman has observed.Most people have little idea of the compensation structures and career paths of Wall Street traders and investment bankers. Or even, for that matter, lower-paid people in other highly-paid service sectors, such as consulting.For instance, a little less than fifteen years ago, an acquaintance of mine who was a retired Fortune 50 CEO was shocked to learn the pay structure of Andersen Consulting's partners. I worked there at the time, for a very skilled managing partner who wore many hats. Between running a large regional industry practice, the local city office of the same industry, representing the Americas for that industry segment, and selling some engagements, he was earning something north of $400K. This would have been in 1993.Further, there were easily at least 50 other managing partners at Andersen making as much or more as my direct manager at the time.My acquaintance was stunned, remarking that in his very large commodity-producing giant, perhaps only three executives were making that much money.Well, compensation is even more disparate on Wall Street.For example, most really good traders are off the floor by age 35. They either burn out or move up the ranks to manage larger 'desks,' and collections of trading units. In the process, it's nothing for a good trader to make a few million dollars per year. The same is true for investment bankers involved in mergers and acquisitions, or active underwriting areas. As business volumes ebb and flow, these amounts will, of course, change.But in general, a young investment bank employee who rises through the trading or M&A ranks can amass compensation worth tens of millions of dollars by his or her mid-thirties. And, as I mentioned in this video post, more young investment bankers are being counseled to remain with their firm, and eschew going to business school for a graduate degree, because it no longer makes economic sense.So, we have the situation of many mid-thirties bankers in a position to 'retire' anytime they wish, and likely own more assets than most Americans will earn in a lifetime of work.If a senior executive at, say, to use Mr. Berman's example, Boeing or J&J, do really well, they might retire with a few million dollars. They make planes, or drugs, or medicines, but are paid in dollars.Traders and investment bankers use, work in, money, and get paid in it, too. And because of the incredible volumes of money that flow through their hands, paying the better players millions per year makes economic sense.Thus, to get back to the answer to my brother's question, old traders and bankers don't really 'retire.'First, on the way up, they realize that risk taking pays. As I wrote in this recent post, which I sent to Mr. Berman, by way of answer to his question,"At diversified financial service firms, managers compete for promotions, compensation and control. In order to win these, they must out-grow their peers.So they take excessive risks in the mid-cycle of a business, riding high growth and turning it into more explosive, riskier growth.Sometimes, this approach works and the executives involved rise to lead the firm. If not, they still get compensated well, and the firm takes the hit to its balance sheet when the risk catches up with the earnings.When I was at Chase Manhattan Bank in the early 1990s, the Real Estate division pushed for high, risky growth via construction lending in Manhattan. Eventually, that bubble burst, leaving the bank to take several hundred million dollars in writedowns in 1990. Meanwhile, the executives who made the loans, often found, upon later auditing, to be improperly documented, if documented at all, received large bonuses for making loan origination quotas.In a large, diversified financial services firm, this drama plays continuously. That is why some element of a diversified financial conglomerate like BofA, Citi, Chase, Merrill, et.al., seems to explode in fantastic losses every few years.In short, it's risk management that brings down large, diversified financial service firms every time. More than anemic growth, excessive growth in one or two businesses inevitably leads to excessive risks, which are typically hidden from the credit and audit functions, as well as senior management. After all, the executives are playing with the firm's money, so it's a win/win or lose/win proposition for them. Either way, their firm takes any losses.The days of smallish Wall Street partnerships in which risks were well-understood, acknowledged, and managed, because the partners owned the risk, are long gone now. Instead, diversified financial mega-firms such as Merrill and BofA own many business units, in which managers play a risky game to advance their careers.Thus, the entire complexion of financial service businesses, markets, and the risks inherent in them, have changed irrevocably, as a function of the sector's current organization. That's why you can expect something like the current Merrill writedowns and firings every few years at one or more diversified financial giants."Remaining direct descendants of the original private partnerships among investment banks- Goldman and Morgan Stanley- still appear to have superior risk management cultures. Newer entrants into the field- Lehman, Merrill, and the large commercial banks- seem to have problems like I described.So you have a lot of 30- and 40-something multi-millionaires who can easily leave one large, public financial services firm, and either: start their own fund, or; join a hedge fund, or; join a private equity shop.Many well-paid, even moderately successful traders and bankers can start their second career in their 40s and make even more money. Or move to a smaller shop and enjoy a somewhat more relaxed schedule, compared to a bigger job, with more pressure, at a large publicly-held investment or commercial bank.Because the rewards for failure are not that bad, and the rewards up until a possible failure are great, virtually nobody in the publicly-held firms has an incentive not to push the boundaries concerning risk to their firm's capital.And that, Mr. Berman, I contend, is the answer to your question. The behavior you are observing is neither bad, nor downright dumb, for the people at these firms. Only for the firms and, temporarily, the financial system in which they exist.Even traders and front-line investment bankers can make enough money over a good five-year run to 'retire' financially secure and ready for their second career, even if they blew their firms up in the process through excessively risky behavior.Are not traders from Amaranth, the commodities firm the blew up last year due to bad bets on natural gas, are already back in circulation?The key to all of this is to realize that in the financial services sector, it's fairly typical for ten-year veterans of the money-making functions- trading, underwriting and M&A- to amass sufficient capital to make them indifferent to being fired, resigning to join a smaller firm, or simply to (more prudently) risk their own capital in a similar endeavor. To these people, mistakes that get them fired simply end a lucrative merry-go-round ride a little early. But not usually too early to walk away in shape for their next act.

Monday, November 05, 2007

My business partner and I were discussing the legal and accounting questions surrounding SIVs, in the wake of this recent (Friday) post, which itself is the latest in a series concerning SIVs and the prospective, commercial-bank funded M-LEC.I wrote on Friday, in that post,

"Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?

Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.

So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?

You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.

They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances."My partner voiced the opinion, with which I concur, that the fundamental problem affecting credit markets right now is the attitudes and practices of management by senior commercial banks (Citigroup, BofA, Chase) and a retail brokerage (Merrill Lynch) firm, to have systematically ignored the risk of such opaque 'structured financial instruments,' both holding them in portfolio, while now attempting to delay the day of marking to market, having underwritten their originations and sold them to institutional customers far and wide.In short, CEOs, risk officers and senior managers across many of these institutions behaved as if the omnipresent realities of credit markets and instruments were somehow suspended or abolished in the case of CDOs and the SIVs formed to hold them.

I wrote, in conclusion, in that earlier post,

"It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing....the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track."

It seems to me that the question of ownership of the SIVs is crucial in the following sense.

Last week, I used Google to attempt to locate, for free, on the web, some reasonable estimate of the total US equities market value, as listed on the NYSE or NASDAQ. I found a seven year old paper by the University of Pennsylvania's Marshall Blume, valuing the US equity markets at roughly $19Trillion, as implied by this statement,

"Again according to the flow of funds, individuals held directly 7.3 trillion dollarsor 39 percent of the total market value of equities held by US investors."It's reasonable to assess the current market's valuation at somewhere in the neighborhood of $24Trillion, by adding the S&P500's nearly 28% rise since 2000 to the estimate in Blume's paper.

This morning, I heard Bill Gross, of PIMCO, the giant bond fund house, estimate the size of the sub-prime mortgage volume outstanding at roughly $1Trillion, and forecast an ultimate loss to defaults of some $250B.Now, in the equity markets, a couple of bad days can result in a 1% loss. This is not at all an atypical occurrence. That is, based upon the prior market size estimate, about $240B.

So, Bill Gross' worst-case loss estimate on sub-prime mortgages, whether securitized or not, is only about a one-two day loss in the US listed equity markets.See my point yet? It's echoed in this piece, in which I found Gross' loss estimate that reinforced his remarks this morning on CNBC.Here is a rough, current equity market value of the five largest US commercial banks:

Citigroup $181BBofA 199Chase 144Wells Fargo 107Wachovia 80

The total market equity cap is roughly $711B. If these banks hypothetically owned all the bad mortgages, and wrote them off, they'd lose more than a quarter of their capital.

Not a good thing for our financial system's stability, is it?

But wait! We know many of these loans were packaged up, or securitized, into CDOs. Many of those are in SIVs, like the seven funds, once worth some $80B, that Citigroup operates. Many others were simply sold to institutional investors the world over.

If the US commercial banks only hold, say one quarter of the bad loans, then writing off $60B in value is no big deal. Heck, Merrill and Citi have already written off, or promised to write off shortly, nearly half that amount.

In the meantime, let's revisit those SIVs and buyers of CDOs. As I noted in the earlier SIV-related post, a lot of those SIV-issued commercial paper were institutional investors. They were being offered unheard-of yields on supposedly-, typically-safe commercial paper.

To illustrate, here's a completely hypothetical conversation that might have occurred (except for the more blunt, honest statements), in abstract, to illustrate my point.

OldBlueIvy: High-yielding? Sounds risky! You know, we can only invest in high-grade securities here at OldBlueIvyEndowment.

BigCity: Yes, I know. But this is a sweet deal. We here at JPCity are operating the SIV. We don't actually own the entity. We have some 'senior note holders' for that. But we, JPCity, wouldn't leave our valued customers holding a bag of worthless paper, you know.

OldBlueIvy: Tell me more about the structure of this 'SIV?'

BigCity: Well, we've raised $5B from the 'owners,' or note holders. Then we're piling on about $95B more in CP. We're going to take that $100B of money, 95% of it short term CP, and buy $100B face-value of high-yielding CDOs with long maturities. It's a lock!

OldBlueIvy: Sounds pretty generous. How do you at JPCity get paid? Why aren't you putting this on your own balance sheet?

BigCity: Well, we're only receiving management fees of 1-2%. Really quite modest, you know, for all of our hard work here. We aren't doing this on-balance sheet because, as you know, for the better part of several decades now, our own credit ratings are often below those of our customers. Thus, we don't really have a balance sheet advantage to give, and it makes no sense for us to hold what the market will risk-price more accurately. Comprende?

OldBlueIvy. Si, I comprende. So OldBlue's endowment won't suffer, because you have locked in a juicy long term spread, to fund your rolling over the CP I'm buying several times a year, right?

BigCity: Yes.

OldBlueIvy: What sort of yield will we get on the CP?

BigCity: Several hundred basis points better than the usual CP you can buy!

BigCity: Not really much at all. As I said, JPCity won't let our customers down on this deal.

OldBlueIvy:Will you be putting that in writing in the CP agreement? Is this CP being sold with recourse?

BigCity. No, of course we won't. But, as I said, we here at JPCity consider you a valued institutional customer. We'd never leave you with defaulted CP. *Wink* *Nod*

OldBlueIvy: Gee, let me think. You're offering me, as a trusted, experienced OldBlueIvy investment committee member, a chance to buy wildly-underpriced CP, without recourse. So I am evidently getting something- that extra yield- for nothing- because you tell me that, although you won't put it in writing, I effectively have recourse to JPCity on this paper.

OldBlueIvy: I'm in. Put us down for $5B!

BigCity: Great! You won't regret it! You're going to be getting some real juicy financial gravy in the form of this extra CP yield. Of course, the only real risk you run is that JPCity lets the SIV default, with its razor-thin 5% equity financing, and you hold worthless CP. With such high leverage, the SIV can't stand much of a fall in the CDO assets it holds, or the whole thing will crumple like a house of cards on a windy day. Now I can tell my bosses at JPCity that I've closed the last tranche of CP funding on this SIV, at no risk to us! We're getting something- your CP purchase- for nothing- we don't have to write into the CP agreement that you have recourse to put back the paper for some minimal value, or its face value.

Admittedly, this is an exaggerated, hypothetical conversation. But I wish to explicitly highlight the implicit 'deal' being struck between the parties.

The investment committee member of the university thinks she is conning the commercial bank by reaping outsized commercial paper yields. The commercial bank SIV debt salesman thinks he is conning the endowment's investment committee by selling them risky commercial paper without recourse.

I think this is, essentially, the case. The investors in SIV CPs have no recourse. And they knew this when they freely invested in the debt instruments of the SIVs.

So, back to my question. If the institutional investors decided, one day, to buy tens of billions of dollars of SIV commercial paper, or even CDOs directly, and they see a $250B loss in market value the next day, what's the big problem?

They comprise a component of the investing market. The US debt markets, in fact, are far larger than the US equity markets. Why is a loss of $250B in value via debt so much worse for institutional investors than the same loss over one or two days in the equity markets?

So long as the commercial banks do not, in fact, own the SIV losses, and CP defaults, their equity capital isn't at risk. Their debt financing reputations might be, but not their capital, per se.

Seems to me that what we have here is, as my partner observed, a lot of managerial corner-cutting by both bank-related SIV operators, and their institutional investment committee customers.

It's fair to say that a lot of these people should probably be suffering serious career consequences for their part in this $250B double-con game. Both parties thought they were playing on the other's naivete and confidence. Many players on both sides look to get burned.

But in comparison to the size of US equity and capital markets, let alone our multi-trillion dollar annual GDP, it's a drop in the bucket.

The biggest problem continues to be that of financial sector companies stalling on taking what losses are appropriate on these ultimately untradeable structured instruments, and the vehicles created to hold them. Once losses are taken, and clean, believable values are quoted, markets will resume their normal operations.

In his place, Bob Rubin, head of Citi's executive committee, becomes interim Chairman, and Sir Win Bischoff, a senior, non-board member of Citigroup, becomes interim CEO.

Will this change Citigroup's near term prospects? Probably not. Here are a few reasons why I believe that- quotes in this morning's Wall Street Journal's Money & Investing section's article from Rubin,

"The direction that Chuck set is exactly where the institution needs to go."

"The board is a very strong board and a very good board."

Just unbelievable. Here's a bank that has engaged in questionable lending practices, via their reputed $80B of face-valued SIVs. Now the bank is reported to be planning additional write downs of $8-11B on their own assets. The hydra-headed cultural monster encompassing the former Salomon Brothers, Smith Barney, and other remnants of Sandy Weill's acquisition campaigns, plus Citi's original quadrapartite consumer-institutional-transactions-asset management businesses, remains out of control.

More sanguine are observers quoted in the Journal piece, such as Doug Kass,

"The board has been part of the problem not part of the solution. They were willing to give more and more rope to Chuck Prince."

It's hard to disagree with these outside observers, when you view Citi's performance going back more than four years. Remember, Weill created a regulatory mess which accelerated his own departure, and left Prince with the job of cleaning that up. Which he largely did.

The trouble is that Citi is an entity which is unlikely to ever be a better investment opportunity, long term, than the S&P500 Index.

As I noted in my weekend post, using this same Yahoo-sourced price chart,

"However, the real damage has been occurring, continually, for nearly four years under Prince. As the nearby Yahoo-sourced price chart for Citigroup and the S&P500 Index shows, the bank has treaded water since late 2003 under Prince's mismanagement."

The problems with Citi included Chuck Prince's ineptitude, but in now way were or are limited to that. The company's structure is now inherently flawed.

In a world of successful private equity and hedge fund shops, all of which have far less business diversification than the modern, large US money center banks- Chase, BofA, and Citi- the hypothesis remains unproven that such a large commercial bank, in so many diverse businesses, can ever provide investors with long term prospects of outperforming the much less expensive, less volatile S&P500 Index.

A lot of people are using Prince's resignation to heap even more accolades on Chase's late-coming CEO, Jamie Dimon. Dimon, of course, was the one-time heir-apparent at Citi, before his mentor, Sandy Weill, fired him. As I wrote here, recently, one quarter does not a successful long term track record, nor business model validation, make.

No, I think Citigroup is simply the worst-managed, most dis-organised of the three American commercial bank Goliaths. None are likely to be a better investment bet, through time, than a broader index, such as the S&P, when risk is considered.

As for Rubin, isn't he up to his armpits in this mess already? Didn't he oversee and favorably pass on the major business decisions, such as the SIV creations, and holding various now-bad assets in portfolio, at Citigroup?

Rubin doesn't actually have a track record as a hands-on manager anywhere. At Goldman, he was Mr. Outside to his co-head, Steve Friedman's Mr. Inside. And at Treasury, Rubin was actually responsible for draining the US financial system of liquidity by retiring the long bond, thus indirectly helping to trigger the 2001 contraction by engaging in unnoticed monetary base shrinkage.

I continue to believe that Citigroup will remain a poorly performing company so long as its current organizational structure and business scope is left intact. The only person who could 'save' Citi, in my opinion, is s/he who would destroy it via spin offs or sales of units, to pare the pieces back to understandable, accountable, motivated sizes which allow for competent management.

About Me

A well-educated veteran of US corporate strategy positions & hedge fund management, as well as research, product development and project work in consulting, strategy and equity management. Academic background in marketing, strategy, statistics and economics.
Currently own Performance Research Associates, LLC, through which I am involved in proprietary equity and equity options investment management.